Q3 Outlook: Optimism versus reality
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Q3 2020 | Outlook: Optimism versus reality For investment professionals only
Q3 Outlook:
Optimism
versus reality
We believe there is a striking disconnect
between market pricing and the real
economy, especially with regard to
expected company earnings.
Emiel van den Heiligenberg
Head of Asset Allocation
Emiel joined LGIM in August 2013 as
Head of Asset Allocation, with
responsibility for asset allocation,
strategy and multi-asset macro
research.
In the past three months, risk assets have pulled back from the So we believe there is a striking disconnect between market
brink of collapse, as policy makers hosed down markets with pricing and the real economy, especially with regard to
stimulus measures and investors turned from pessimists to expected company earnings.
optimists. We believe some of that optimism is misplaced.
When we plug our economists’ scenarios into earnings models,
As a result, our overall strategy remains broadly the same, with we need to make quite aggressive positive assumptions to
a cautious stance on global equities. In our view, markets are justify the current level of equities. We believe US earnings are
exuding over-confidence on the outlook for the economy, the likely to suffer a peak-to-trough fall of about 40%. Markets are
path of COVID-19 and the development of a vaccine. Indeed, clearly not pricing this in.
over the next six months, we expect to see mounting evidence
of ‘economic scarring’, due to corporate defaults, layoffs and In a recovery, of course, investors will look through this decline.
cuts to capital expenditure. Yet even if we plot end-2021 earnings – so a fall and then a
bounce – we think stocks still look expensive.
It is true that data compiled by our economics team suggest
the great re-opening of economies appears to be proceeding
somewhat faster than anticipated, with no clear sign yet of an
increase in infections in those economies that have relaxed
restrictions.
But regardless of whether you expect a V- or W-shaped
recovery, the data are likely to improve for a while as the major
economies begin to roll back containment measures. We think
markets are underestimating the risk that growth weakens
again, after the initial euphoria of exiting lockdowns, with many
people remaining on government support.
Q3 2020 Outlook: Optimism versus reality
Long tech, short gilts Our views at a glance:
A fair amount of the optimism can be explained by the massive Equities – While we remain tactically negative, we have pared
fiscal and monetary support deployed, not least extremely low this stance as the shape of the recovery remains unclear.
interest rates. This is inflating asset prices, giving a sense of ‘all Our medium-term view remains neutral in light of valuations,
clear’ despite much of the stimulus being only temporary. particularly relative to government bonds.
Duration – We are slightly negative in the short term. We
Even though we believe equity markets have rebounded too far
expect central banks to keep yields low as they seek to prop up
and too fast from their March lows, we remain positive on tech
economies, although yields are likely to rise over the medium
stocks, as they are likely to constitute a winning post-pandemic
term as the world returns to ‘normality’, in our view.
sector, in a low-growth environment where technology
becomes a strategic industry, in our view. Credit – We have shifted our medium-term view on IG from
positive back to neutral as spreads have contracted.
We also think equity laggards, which underperformed in the
rally, have further to run. But we have taken some profits on our Overview Equities
long-credit stance as spreads have contracted massively,
Equities ● ● ● ● ● US ● ● ● ● ●
returning the risk-reward ratio to more normal levels. Duration ● ● ● ● ● UK ● ● ● ● ●
Credit ● ● ● ● ● Europe ● ● ● ● ●
A new position we have introduced in portfolios of late is short Inflation ● ● ● ● ● Japan ● ● ● ● ●
Real estate ● ● ● ● ● Emerging markets ● ● ● ● ●
gilts, reflecting our view that core rates are likely to rise more
than forwards are pricing. This is because we believe:
Fixed income Currencies
• Fears over the advent of negative yields in the US and UK
Government bonds ● ● ● ● ● US dollar ● ● ● ● ●
are overdone Investment grade ● ● ● ● ● Euro ● ● ● ● ●
High yield ● ● ● ● ● Pound Sterling ● ● ● ● ●
• Supply from government issuance will outweigh central EM USD debt ● ● ● ● ● Japanese Yen ● ● ● ● ●
EM local debt ● ● ● ● ● EM FX ● ● ● ● ●
bank purchases
= Strategic allocation
• Inflation expectations are likely to rise as policymakers
experiment with ‘helicopter money’ and politicians grow
This schematic summarises the combined medium-term and tactical views of
addicted to fiscal stimulus LGIM's Asset Allocation team as of June 2020.
The midpoint of each row is consistent with a purely strategic allocation to the
Elsewhere, we still like buying inflation-protection in the US, for asset/currency in question. The strength of conviction in our medium-term and
similar reasons, and also favour gold as an alternative asset. tactical views is reflected in the size of the deviation from that mid-point.
Summary of LGIM’s asset allocation core view
Economic cycle
0 +1 • Cycle moving much faster than a normal
-1
recession
+2
-2
• Social distancing sectors have upside potential
+3
-3
Neutral • Cyclical outlook dependent on vaccine progress
overall
and economic scarring
0 +1 0 +1 0 +1 Valuations
-1 -1 -1
• US absolute valuations very expensive, ROW
+2
+2
-2
-2
+2
-2
reasonable
+3
+3
+3
-3
-3
-3
• Relative valuations still very attractive, in our
view
• Relative valuations more relevant than absolute
Economic cycle Valuations Systemic risk
Nature of recovery Relative valuations Concerns around both Systemic risk
dependent on still very attractive, in political and credit risk
economies opening up, our view • Troubled relationship between
3 US and China
virus suppression and • Chinese housing market a concern
success of vaccine • Focus on downgrades and defaults in the US
deployment
2
Q3 2020 Outlook: Optimism versus reality
Portfolio role
Although currency weakness is hardly a sign of strength, we
believe it can be quite useful in the context of a global multi-
asset portfolio.
Willem Klijnstra
Strategist When you buy a foreign asset, you receive the foreign currency
exposure, too. Long-term expected returns on currencies are
close to zero, as exchange rates are relative prices and the
A spoonful of sterling... uncovered interest rate parity theory, which suggests that
differences in interest rates will equal the relative change in FX
The pound is sitting on a sizable year-to-date decline versus rates over the same period, generally holds.
major rivals, presenting us with an opportunity to look again
However, this does introduce extra short-term volatility. Within
at the idiosyncratic factors that affect its performance – and
a portfolio context, some of that extra volatility can be helpful,
the role of foreign-currency risk in multi-asset portfolios with
as it diversifies other risks in the portfolio.
sterling as a base currency.
The degree of diversification depends on the base currency of
Risk-on currency
the investor. For example, for a sterling-based investor holding
Over the last few years, Brexit was often the usual suspect for
US stocks, un-hedged through March, meant a loss on the
any sterling weakness. It may have played such a role again
stocks in US dollars terms – but a smaller loss when translated
earlier this year, but we believe the currency has mainly been
into sterling. For a dollar-based investor, it is actually the other
driven by its more traditional risk factors.
way around, where the weakness in their UK stock holdings
We often say sterling acts as a risk-on currency, for a number would be compounded by the loss in sterling.
of structural reasons. The UK is a large global financial centre
So, some currencies can act as a shield for investors in risk-off
and it runs a large structural gross foreign asset position.
periods, such as the greenback, while others boost the returns
Losses on financial markets, as a consequence, typically do
on foreign assets in good times, or make the situation worse in
not bode well for the pound.
bad times, as we saw with sterling this year.
As a net asset owner, a bull market is better than a bear
To hedge or not to hedge?
market, while the City thrives on more financial activity.
Drawing all of this together, some foreign currency exposure
Unfortunately, COVID-19 has dampened activity and triggered
can be beneficial, but too much and it will start dominating
weakness in markets, broadly speaking.
portfolio outcomes.
H1 2020: A rough ride for the pound What is ultimately required, in our view, is a balancing act that
depends on the base currency. We hedge a substantial part of
102 the foreign currency exposure in our global multi-asset
portfolios via currency forwards and/or futures, but for the
100
reasons outlined above, not all of it.
98
96
94
92
90
Jan-20 Feb-20 Mar-20 Apr-20 May-20 Jun-20
Trade-weighted average value. Source: Bloomberg, Bank of England, as at 30 June 2020
3
Q3 2020 Outlook: Optimism versus reality
Grant designs
Through the disbursement of proceeds according to economic
need rather than just impact from COVID-19, the plan takes
account of the less favourable position of some southern
Hetal Mehta
states which are still suffering from the aftermath of the
Senior European Economist
sovereign debt crisis.
It thus seems that high-debt countries will be the primary
The EU recovery fund: signal and beneficiaries. In addition, the repayment terms appear more
substance favourable than had been expected.
Still, the pace of implementation could be seen as slightly
Market participants have grown accustomed in recent years to
disappointing, with only €120-150bn scheduled to be raised in
the EU dealing with crises in a fairly reactive manner, often
2021 and the remainder to take place in subsequent years out
hammering out solutions at summits that continue late into the
to 2024. Moreover, at less than 6% of European GDP, the
night and are accompanied by large amounts of nail-biting.
proposal is clearly not sufficient to absorb all of the virus-
related costs.
So, in late May, investors were pleasantly surprised to see
details from the European Commission on its decidedly
Strong signals
proactive plan for a European recovery fund.
As important as the fund is, we should also bear in mind the
broader objective of signalling European solidarity and
Building on an initial proposal from France and Germany, this
establishing a framework for risk-sharing that could be
envisages the EU borrowing €750bn in order to provide €500bn
revisited in future crises.
in grants to countries most affected by COVID-19, as well as
another €250bn in loans.
We also think it needs to be viewed in context of other support
from the European Central Bank, the Support to mitigate
In our view, the grants represent an important symbolic step
Unemployment Risks in an Emergency (SURE) programme,
closer to debt mutualisation among member states. First,
European Investment Bank, and European Stability
leaders have recognised the need for fiscal transfers among
Mechanism.
member states. Second, it would be conducted through joint
issuance, albeit backed by the EU-27 budget, showing a greater
Taken together, we believe there is more than enough here to
understanding that a priority is to minimise the cost of debt
allay market concerns – particularly over peripheral assets – in
issuance and avoid burdening national balance sheets.
the near term.
And while the additional €250 billion in loans may not be fiscal
Still, turning the recovery fund into reality is unlikely to be a
transfers, nor can they be excluded from a member state’s
smooth process, as all EU national governments will have to
debt/GDP ratio, they do offer further lower-cost support for
ratify it. Expect a few more nail-biters over the summer.
‘peripheral’ countries.
Proposed allocation from the European Commission for EU Recovery Fund, net gain (+) / loss (-)
25
20
15
10
5
0
-5
-10
Gr ia
ce
ia
Po ia
Ro al
th a
Po ia
nd
Fr a
Be e
m
Sw d
Au n
ria
Ge ds
De ny
Ire rk
nd
g
Hu n
Cy ry
a
M a
us
ly
ta
Bu ia
c
i
ni
i
hi
ur
e
ai
an
Ita
t
ar
tv
ak
g
an
n
en
a
a
al
iu
a
ee
an
pr
n
ed
oa
st
la
la
ua
to
ec
Sp
rtu
ng
nm
bo
rm
La
la
lg
nl
lg
ov
ov
m
Cr
Es
Cz
er
Fi
m
Sl
Sl
th
Li
xe
Ne
Lu
Source: EC, as at May 2020
4
Q3 2020 Outlook: Optimism versus reality
Value / growth (Europe)
1.70
Lars Kreckel 1.50
Global Equity Strategist
1.30
1.10
Is it finally the time for value to 0.90
shine?
0.70
Many investors, pondering the relative performance of investment
0.50
factors in recent years, will probably have asked at some point: “Is it Jan-95 Jan-99 Jan-03 Jan-07 Jan-11 Jan-15 Jan-19
time to go long value?”
Value stocks, which trade at low prices relative to their MSCI Europe Value / MSCI Europe. Source: Bloomberg, LGIM as at 1 July, 2020
Past performance is not a guide to the future.
fundamentals, have indeed underperformed by so much – and for
so long – that they have long appeared to be due a bounce. But the
Structural headwinds
correct answer would almost always have been simply “no”.
All of the above (and more) have been valid for a long time,
even as value has continued to lag the broader market. What is
Now, though, the answer should be far less emphatic, in our view,
new is that we believe the macro backdrop for value is likely to
as a key element that could trigger a rally in value is changing, even
look more favourable in the months ahead than it has in many
if only on a temporary basis. Indeed, this has prompted us to
years.
rephrase the original question: “If not now, when?”
High-frequency cycle data have already started to improve,
Performance and popularity
with the countries emerging from lockdowns and the global
Value stocks have been terrible relative performers pretty
economy recovering from recession, albeit only fitfully and to
consistently since 2006; they currently trade at around 20-year
below their pre-crisis levels of activity.
lows versus the wider market. Value has now underperformed
during the last two bear markets, the long bull market in
Improving PMIs have tended to be good news for value. An
between and has not outperformed in the sharp market
arguably even more important and more durable factor is that
rebound since late March.
we are likely to soon enter the part of the economic cycle that
has typically delivered the best risk-adjusted returns for value:
Perhaps unsurprising given the poor performance, value
early cycle.
stocks are located in a very unpopular part of the market,
where little of the optimism that Emiel cites is priced in.
Mapping equity returns to the stages of economic cycles
suggests that value has delivered its best risk-adjusted returns
Relative valuations have fallen a long way: whether you look at
during the first part of expansions.
price-to-earnings or price-to-book ratios, or dividend yields,
most such metrics are at or near long-term extremes. At the
A word of caution, though. Even if the cyclical outlook for value
same time, sentiment data mirror the valuation discount, with
improves, we expect the structural headwinds of a low-growth,
investor surveys consistently highlighting value near the
low-inflation and low-bond yield environment over the medium
bottom of the popularity rankings.
term to remain. As a result, we see potential opportunities in
value stocks as more tactical than structural.
5Contact us For further information about LGIM, please visit lgim.com or contact your usual LGIM representative Important information Key risks Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Views expressed are of Legal & General Investment Management Limited as at July 2020. Forward-looking statements are, by their nature, subject to significant risks and uncertainties and are based on internal forecasts and assumptions and should not be relied upon. There is no guarantee that any forecasts made will come to pass. This document is designed for the use of professional investors and their advisers. No responsibility can be accepted by Legal & General Investment Management Limited or contributors as a result of information contained in this publication. The information contained in this brochure is not intended to be, nor should be construed as investment advice nor deemed suitable to meet the needs of the investor. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be solely relied on in making an investment or other decision. The views expressed here are not necessarily those of Legal & General Investment Management Limited and Legal & General Investment Management Limited may or may not have acted upon them. This document may not be used for the purposes of an offer or solicitation to anyone in any jurisdiction in which such offer or solicitation is not authorised or to any person to whom it is unlawful to make such offer or solicitation. No party shall have any right of action against Legal & General in relation to the accuracy or completeness of the Information, or any other written or oral information made available in connection with this publication. As required under applicable laws Legal & General will record all telephone and electronic communications and conversations with you that result or may result in the undertaking of transactions in financial instruments on your behalf. Such records will be kept for a period of five years (or up to seven years upon request from the Financial Conduct Authority (or such successor from time to time)) and will be provided to you upon request. © 2020 Legal & General Investment Management Limited. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272. CC4802020
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